Economists don’t have much of a reputation as delightful company. Some people talk in their sleep, but economists talk in other people’s sleep.
Three basic questions of economics:
- What should be produced by a society?
- How should it be produced?
- Who gets to consume what is produced?
Trade-offs should be taken seriously. Well, everybody believes that, right? Actually, no, they don’t. Think about the question of whether, if a government needs to raise additional revenue, it should raise the tax on individuals or on corporations. In public discourse, this tends to boil down to asking, “Which do you care about, corporations or people?” But an economist sees the bigger picture. If you raise taxes on corporations, where do the corporations get the money? They could raise the prices of their products sold to consumers; they could cut the bonuses of top executives; they could cut the dividends they pay to stockholders — all of which would mean less money in the pockets of some actual person.
The eraser is a mixture of vegetable oil fro the Dutch East Indies, pumice from Italy, and various binding chemicals — imagine how many steps that is for the eraser alone. In the essay, Read claims that there is no single person in the world who could make a pencil from scratch, and he may well be right.
The overwhelming majority of Americans have never grown food, caught game, raised meat, ground grain into flour, or even fashioned flour into bread. Faced with the challenge of clothing themselves or building their own homes, they would be hopelessly untrained and unprepared. Even to make minor repairs in the machines that surround them, they must call on other members of the community, whose job it is to fix cars or repair plumbing. Paradoxically, perhaps, the richer the nation, the more apparent is the inability of its average inhabitants to survive unaided and alone.
So how can we coordinate what goes in and what comes out of the storehouse? Unfortunately, the honor system is not a practical solution. Think about what happens in a dormitory refrigerator. If a dorm has a common fridge, you put things in and you hope that everyone will replace what they’ve used and that you’ll always have milk for your morning coffee. But this never works in a dormitory. It won’t work well in the economy at large, either.
In the first of the three markets — the goods market — where do prices come from? When many noneconomists talk about prices, they talk about prices being “too high” or “too low,” which is best understood as a way of comparing the world as it is to the world as they think it ought to be. You’ll hear statements such as “nurses are paid too little” or “gasoline costs too much.” To an economist, this sort of judgment is like saying the weather today is “too cold” or “too hot.” It tells you something about the preferences of the person, but nothing about why things are as they are.
To noneconomists, prices are typically value-laden. Economists try to avoid those sorts of value judgment, which we call the diamond water paradox.
Just as there’s often confusion between “demand” and “quantity demand,” there’s a parallel confusion between “supply” and “quantity supplied.” Quantity supplied refers to the specific amount produced at a given price. Supply refers to how much is produced at every price. Quantity supplied is a point, and supply is a curve.
Equilibrium is the point toward which a market economy tends — but that’s not to say that markets are always at equilibrium. There are long-standing disputes over how long it takes markets to reach equilibrium, how close they usually are to equilibrium, and when or whether market prices will overshoot equilibrium and need to bounce back.
Any change in demand or supply — remember, that’s a change in the whole curve — will cause the equilibrium point to shift. Consider, for example, the market for beef. If income rises, then the demand for beef rises. The result would be a situation in which the new equilibrium has a higher price and quantity sold in the market.
In the real world, equilibrium means only that quantity demanded and quantity supplied are in balance, it doesn’t mean that people feel content with the result. Some buyers will always say, “I think I’m paying too much.” Some sellers will always say, “I can’t believe it’s selling for so little.”
One common complaint about the supply-and-demand model is that “real people don’t think that way.” At one level, this is obviously true: most people don’t use these terms or draw graphs in their heads. But as long as buyers search for what they prefer at the lowest possible price, taking their desires, their finances, and their possibilities for substitution into account, and as long as firms adjust their production in response to changes in price, the supply-and-demand approach will work reasonably well. The reality of supply and demand may not always be likable, or morally attractive, or desirable in any deep philosophical sense, but it is a useful tool — a powerful and accurate way of describing and understanding why prices are at the levels they are and why prices might be rising or falling. It works as a way of describing markets all over the world, at all different times in history, and for all sorts of products.
Disagreements about price and quantity in a market are impossible to avoid. Suppliers will always say if they just had a little more money, they could create new jobs, build new factories, hire more people. Demanders will always talk about the difficulties of trying to get by at their income level. Both sides will appeal to fairness. Businesses will say they just want a “fair” price — by which they mean a higher price. Individuals will talk about how the price of rent or electricity or gasoline is “unfair” — by which they mean the price should be lower. If a group is politically powerful enough, it can sometimes push a government into changing the law to enshrine its advantage.
Ironically the political system tends to choose price floors and price ceiling precisely because they’re not especially good public policy tools. Whereas economist force themselves to acknowledge the trade-offs in any scenario, politicians often prefer to hide the costs of their policies. Price floors and ceilings look like policies with a zero cost because they don’t require a spending increase or a tax cut. Price controls sweep the costs under the rug.
Raising price brings in more revenue if demand is inelastic, but not if demand is elastic.
Demand and supply are often inelastic in the short run and elastic in the long run.
Labor unions are another controversial aspect of labor markets. People tend to have strong emotion reactions to unions. Here, let’s try to step back form the emotions and look at how unions function in an economy. Labor unions serve two basic functions. First, they seek to raise the wages of their members through contract negotiations, with the threat of a strike looming in the background. If the union is particularly hard-nose in negotiations, odds are that the industry’s employers will, over time, find ways to shrink the unionized workforce. The employer might do this through labor-saving machinery, through subcontracting and outsourcing to nonunion labor, and so forth. As a result, the size of militant unions will usually diminish over time; to some extent, that’s what happened with the steel- and auto- workers’s unions in the US.
The second function of a union is to build a better, more productive workforce. The union accomplishes this through some obvious means, such as apprenticeships, and some more subtle ones, such as giving workers a sense of community and emotional investment in the quality of their work. The union acts as a voice for the workers, communicating their concerns and needs to employers. These two functions of unions can seem contradictory but most unions act each way at different times.
For private industry workers, on average about 70 percent of their total compensation comes in the form of wages, with the rest in the form of benefits. For example, about 10 percent of total compensation is retirement benefits, including Social Security, Medicare, pensions, and retirement saving accounts. Another 6 percent or so is vacation leave, and 6-7 percent is health insurance. But for any worker, when your employer offers you those “generous” benefits, you’re still the one who’s paying for them, in the form of lower take-home pay.
People may feel that the price in a goods market or the wage in a labor market isn’t fair, but rarely do they feel that such payments should be treated as illegitimate. However, many people do have a nagging sense that the payment of interest — which is the price in a financial capital market — is somehow wrong. Why might this be?
One likely reason is that the essence of what is being exchanged in a financial capital market can be hard to grasp. Goods and services are tangible and visible. But the interest payments and returns on financial capital are more abstract, and the workings of the financial market can seem invisible.
Financial capital markets can be interpreted using the same supply-and-demand framework as markets for goods and markets for labor. The supply of financial capital comes from those who save financial capital. We typically think of this supply of financial capital as coming from households. Firms save money, too, but since firms are owned by shareholders — and thus ultimately by households — you can think of firms who save as doing so on behalf of households.
The interest rates paid on bonds vary depending on risk. A highly profitable firm such as Walmart could issue bonds at a relatively low rate of interest because people know it is likely to repay. Likewise, governments — at least stable ones — issue bonds at low rates of return. On the other hand, a less stable firm might issue a high-interest-rate, high-risk bond, which is sometimes called a “junk bond.”
Selling stock is often a way for younger and smaller companies to raise money.
Your age — or, more specifically, how far you are from retirement — should figure into your financial investment choices as well. After retirement, most people aren’t earning much income; therefore, they don’t pay a lot of taxes, and the tax break doesn’t matter as much to them. But during their main earning years, say ages thirty to fifty-five, most people will have higher income and tax bills, and so tax breaks will matter more.
A final set of investments available to individuals is precious metals — gold, platinum, and so on. These are among the riskiest investments an individual can make. Prices move sharply in precious metals markets. If you time the buying and selling just right, you can make a lot of money, but if you time it wrong, you can take a spectacular loss. On the sleeping scale, we’re talking bouts of insomnia.
The stock you really want to buy is the one that, right now, everyone else thinks will do poorly but that in the future, everyone will think will do great. Maybe — maybe — a sophisticated professional investor who works sixty or eighty hours a week can pick those kinds of stocks on a regular basis. But if you’re sitting at home looking at the Wall Street Journal, which was written yesterday about news that happened the day before that, you need to understand that professionals in the stock market knew much of that information weeks ago.
In the US economy, firm size ranges from single-person operations to megacorporations. There are three broad types of firm ownership. Proprietorships are owned by a single individual. Partnerships are owned by a group of individuals. Corporations are organizations that have a legal existence independent of their owners; thay may be owned by an individual or a group of stockholders. In the early 2000s, there were about 18 million proprietorships, 2 million partnerships, and 5 million corporations in the US economy. But corporations, although not the biggest group numerically, dominated in size. Those 5 million corporations had about $20T in sales, whereas the 2 million partnerships had only about $2.5T in sales. The 18 million proprietorships combined had a total of about $1T in sales.
The key characteristic of a perfectly competitive industry is price taking — that is, perfectly competitive firms must take the market price as given. Firms in these industries have no choice but to be price takers because, from the consumer’s point of view, substitution is easy. Firms can enter and exit a perfectly competitive industry easily because the products tend to be straightforward to make; they’re usually well-understood objects such as socks, wood screws, and so forth.
Monopolies don’t have to take their profits in only monetary form, however. “The best of all monopoly profits is a quiet life.” With no competitors, you can relax a bit. In a perfectly competitive market, you can’t relax for a minute. At their worst, monopolies have a choice between lazy inefficiency and the ability to suck consumers dry through higher prices.
In the US the primary federal agencies that carry out antitrust and competition policy are the FTC and the DoJ. The FTC is an independent agency that reports to Congress. It’s headed by five commissioners who are nominated by the presidents and subject to confirmation by the Senate. They server 7-year terms, and no more than three of them may be members of the same political party. The DoJ has an antitrust division dedicated to investigating and prosecuting antitrust cases.
A classic legal case of the problem of defining the size of a “market” was decided in 1956. The DuPoint company was accused of monopolizing cellophane production. DuPoint readily admitted that it produced, at that time, about 70 percent of all cellophane. However, the company said that the right way to define a market was as all “flexible packaging materials,” which included all sorts of other products, such as waxed paper.
Not only does the US government have the power to block or constrain mergers, but it can also break up large firms if they are found to be monopolies.
As with other crimes that cross national borders, it can be difficult to determine who has the authority to prosecute a cartel. For example, members of OPEC get together to set oil prices, but under whose law are their acts illegal, and who can prosecute them?
In some industries, market competition isn’t likely to work well. Instead, it leads to a situation in which all firms can suffer enormous and unsustainable losses. Back in the late 19th century, the US railroad industry seemed to be booming. The biggest outlay that firms had was the cost of laying track; once that was done, the cost of moving goods along those tracks was low. If a company had the only tracks in a given area, it could charge high prices for shipping goods and use the profits to pay high dividends, which attracted more investors, which gave the company the money to lay more track, and so on.
Competition doesn’t work very well among public utilities, either. Why not? Try to imagine a city with four separate water companies; that’s four sets of pipes, one for each company, under every building in the city. It’s not viable. Many water and electrical companies are technically privately owned, but they are closely regulated by the government.
Thus, in some cases the answer to the best form of regulation has been to deregulate. The US economy experienced a wave of deregulation in a number of industries in the late 1970s and early 1980s. Deregulated industries included airlines, banking, trucking, oil, intercity bus travel, phone equipment, long-distance phone service, and railroads. When these industries were deregulated, they stopped being nice, neat, orderly markets with a predictably high level of profit year in and year out. Yet by the end of the 1990s, America’s great deregulation experiment of the 1970s was saving consumers about $50B a year in lower prices.
“Command and control” is the name economists give to the kind of regulatory policies that specify a maximum amount of pollution that can legally be emitted.
Edison’s first invention was a vote-counting machine. It worked just fine, but no one bought it and Edison vowed from then on to make only inventions people would actually buy.
What has changed is the demographics of the poor. Back in the 1960s and ’70s, if you had to describe the poor in a single word, the word “elderly” would have been a reasonable choice. That’s no longer the case today, thanks to help from Social Security, Medicare, and similar programs. The poverty rate among the elderly is now no hinger than among other age groups. For some years now the group that is disproportionately poor has been best described as single-parent households headed by a woman.
Economists call this problem a “negative income tax.” A negative income tax arises when the government reduces welfare benefits as a person earns additional income. Contrast this with the familiar positive income tax, in which you earn money and the government takes part of that money. Both kinds of taxes reduce the incentive to work.
At a fundamental level, we care about poverty and inequality for different reasons. Poverty cuts into a person’s ability to consume the basic necessities of life. Inequality concerns us more out of a sense of fairness, a feeling that in a just society the rewards and disparities should not be primarily distributed by birth or family connections or even luck, but should have some reasonable relationship to people’s efforts and skills.
The first big problem is called moral hazard, which means that having insurance leads people to take fewer steps to avoid or prevent the bad event from happening in the first place. The insured have a little bit less incentive to change the habits or improve the conditions that make them more vulnerable to a negative event.
The other big issue is the problem of adverse selection. Those who are especially likely to experience the bad event are more likely to purchase insurance, while those who are very lock risks are less likely to purchase it.
Another problem what arises in both corporate and political principal-agent problems is that there are a vast number of principals, which raises a variation on the free-rider problem. For any individual principal, the effort to monitor the agent may be too much effort. After all, among thousands of shareholders or millions of voters, why should you be the one spreading the time, cost, and energy to monitor the performance of the leader? Add to this the fact that a lone shareholder or voter’s opinions might not hold much sway with the agent unless that shareholder or voter has support from many other principals. To put it another way, if individual principals lack power to control the agents, the the agents will lack an incentive to act in a way that will benefit the principals.
How does a company go from being a role model to having its top executives threatened with jail in less than a year? What safeguards were supposed to be in place that failed to work? For starters, the individual shareholders lacked power and the incentive to monitor top executives. In most companies, shareholders elect a board of directors, who are directly responsible for the hiring and monitoring of top executives. But quite often those same executives are the ones who decide who can run for membership on the board. The independence and neutrality of the corporate board of directors can be questionable. Being a board member is also a part-time job. It consists of a few big meetings a year, where the information and the agenda are provided by the same top executives. So an aggressive board of directors can provide some oversight, but there are limits to what it can do.
For example, in 2003, Fortune magazine ran a prominent story questioning what was going on at Enron, but few other watchdogs barked. After all, stock market analysts’ pay and, to some extent, their access to information is determined by whether they are viewed as good team players. The same is true of business journalists and bankers. No one wants to be the skunk at the garden party, because they won’t get invited back.
Why don’t people vote? In most elections of any size, the margin of victory is measured in hundreds, or thousands, or even millions of votes. A rational vote will recognize that one vote is not likely to make a difference, and thus many of them will not bother to become informed or vote.
The four goals of macroeconomic policy are: (1) economic growth, (2) low unemployment, (3) low inflation, and (4) a sustainable balance of trade. The two main sets of tools are fiscal policy and monetary policy. Fiscal policy is government tax and spending policy, including the federal budget and budget deficits. Monetary policy refers to the policies of the Fed, which affects interest rates, credit, and how much money is being loaned and borrowed in the economy.
Many other things affect people’s standard of living and their happiness but cannot be measured as things that are bought and sold. For example, if everyone worked ten hours a week less or had an extra two weeks of vacation every year, but output remained the same, GDP would not show any overall gain. Greater or lesser pollution levels don’t show up directly in GDP measures. Negative events, such as a natural disaster, can lead to the rebuilding of a large part of a city, which makes short term GDP look positive, but the locals have clearly suffered a lower standard of living.
The lesson here is that seemingly small differences of a few percentage points in the annual growth rate have a huge effect. In the long run, you can argue that economic growth is the only thing that matters to the standard of living.
The underlying cause of long-term economic growth is a rise in productivity growth. The three big drivers of productivity growth are an increase in physical capital, that is, more capital equipment for workers to use on the job; more human capital, meaning workers who have more experience ore better education; and better technology, that is, more efficient ways of producing things.
The official government unemployment rate is based on a monthly survey that records how many people do not have work and are presently looking for work. A person who does not meet both of those conditions is counted as “out of the labor force.” About one-third of all US adults are considered to be out of the labor force.
Thus, economists have turned their attention to the so-called implicit contracts that workers have with their employers. For most employees, wages are fairly fixed over a given year; that is, your salary is the same in a month when business is bad as it is when business is good. Firms also prefer not to cut wages, because they fear what it might do to the morale of their existing workers — and perhaps especially the morale of the better workers in a firm. When the economy falls into recession and the demand for labor drops, firms are highly reluctant to cut wages; instead, they stop hiring or even lay off existing workers.
Why is inflation bad? This may seem like another of those questions only an economist would ask. Isn’t it obvious that we don’t want to pay higher prices? Well, not exactly. Here’s a thought: inflation isn’t necessarily bad — if it happens everywhere at once. Imagine that one night, magic money elves sneak into every wallet, every purse, every bank account, and they double the money everywhere in the economy. All the storekeepers know what’s happened, so the double all the prices on everything. So though everyone has twice as much money, they’re no better off than they were the day before.
In the real world, however, inflation is not evenly distributed, and it’s not fully predictable. As a result, it will benefit some groups and impose costs on others.
To economists, a trade deficit literally means that a nation, on net, is borrowing from abroad and receiving an inflow of investment from abroad. For exactly the same reason, a trade surplus literally means that a nation, on balance, is lending money abroad and having an outflow of foreign investment. A trade surplus and trade deficit aren’t just about the flow of goods. In fact, to most economists, trade imbalances aren’t even primarily about the flow of goods. They’re about this flow of money, and whether the flow is bigger in one direction or another.
Indeed, borrowing from abroad makes economic sense, as long as there’s sufficient economic growth in the future to pay back the loan. But if there isn’t sufficient growth, borrowing from abroad can turn out badly.
If the trade deficits are macroeconomic in nature — if they’re about national saving rates, national investment rates, government budget deficits, and the like — then many of the most common arguments you hear about trade deficits are misguided. For example, it’s common to hear people say, “The US trade deficit happens because of unfair foreign trade practices such as shutting out US products and flooding the US goods market with cheap exports.” But from the perspective we’ve been discussing, those trade practices have literally nothing to do with US trade deficits. Again, think about the pattern of US trade deficits over the past few decades. If you think unfair foreign trade practices cause trade deficits, you need to believe that foreign trade was pretty fair in the 1970s, then got deeply unfair in the mid-1980s, then became fairer in the early 1990s, then got unfair in the late 1990s, and even more unfair in the 2000s.
There’s no such patter in the data. For example, in the US economy, exports in recent years have runt at about 10 or 12 percent of GDP, yet the US economy has humongous trade deficits. Japan has a similarly low figure for exports yet it has huge trade surpluses. Why the difference? Japan has an astonishingly high private savings rate and somewhat lower levels of domestic investment versus the US. That money has to flow somewhere, and it flows out of the country in the form of trade surpluses.
Moreover, Keynesians are concerned that the macroeconomy can become stuck below potential GDP for a long time. Even if the economy gradually returns to full employment in the long run without government action, as Keynes famously wrote, “In the long run, we’re all dead.” Waiting for the long run has large costs; if the economy takes years to readjust, that’s a huge chunk of people’s lives and careers.
The starting point for understanding the potential power of fiscal policy is that the US federal budget is huge. Roughly speaking, federal government spending has accounted for about 20 percent of US GDP over recent decades. The US GDP is approximately one-quarter of world GDP. Thus, the US government’s annual budget is 5 percent of world GDP. It’s fairly common around the world for government spending to make up one-third, one-half, or even more of a nation’s GDP. The sheer size of government spending around the world commands attention.
Conversely, defense spending is enormous, and it’s grown since the terrorist attack of 9/11, but the biggest single chunk of the federal budget is aimed at the elderly: Social Security, Medicare, and federal retiree benefits make up almost half of the federal budget. This pattern helps explain why it’s politically difficult to cut federal spending.
The main categories of federal taxes, which make up 95 percent of the total, are individual income taxes, corporate income taxes, payroll taxes for Social Security and Medicare, and the excise taxes — that is, taxes on gasoline, cigarettes, and alcohol. For 2009, 43 percent were individual income taxes, 6.6 percent were corporate taxes, 42 percent were Social Security and Medicare, 3 percent were excise taxes, about 1 percent were the estate and gift taxes, and the rest of federal tax revenue was made up of smaller taxes such as customs duties and miscellaneous fees.
A fourth concern that applies to both discretionary and automatic countercyclical policy is that these measures can be a little like taking aspirin when you’ve got a bad case of flu: it numbs the pain so that you feel better, but it doesn’t directly address the underlying infection. Macroeconomic fiscal policy doesn’t address questions such as how to make the US economy less susceptible to oil price shocks, or how to address price bubbles in technology stocks or housing, or how to design a financial system that is less susceptible to crisis. Fiscal policy can ease the pain of a recession, at least somewhat, but the underlying causes of recession still need to be addressed and worked through by both private market and the public sector.
The question of whether to implement fiscal policy through tax policy or spending policy is often made on partisan lines. Conservatives and Republicans often prefer to conduct expansionary fiscal policy with tax cuts and contractionary fiscal policy with spending cuts. Conversely, liberals and Democrats often prefer to conduct expansionary fiscal policy with spending increases and contractionary fiscal policy with tax increases.
Never forget that government borrowing is part of the overall picture of national saving. In the US economy, the federal government is one of the two big demanders of investment funds — the other being private firms who want to borrow for physical capital investment. The two big suppliers of financial capital are private savings and the inflow of foreign capital. So, if the federal budget deficit goes up, some combination of the following three things must happen: private savings must go up, private investment must fall, or inflow of foreign capital must increase. The trick lies in understanding which one, or which combination, is likely to happen.
What is money? It seems a simple question, but the answer is surprisingly complex.
In a casino, chips might serve as money within the four walls of the casino; inside, you can exchange chips for food and drinks, for a room, or for souvenirs. But once you leave the casino, they’re not money anymore, because you can’t exchange them for most things.
Notice that currency (bills and coins) is only one slice of the total money supply. Currency is only about half of M1 and about one-tenth of M2. Thus, when you’re thinking about money in a modern economy, you shouldn’t be thinking about bills and coins; you should be thinking about bank accounts.
A common question at this point is “What about credit cards and debit cards? How do they fit into the picture?” They aren’t money. A credit card is just a method of short-term borrowing. A debit card is linked to a bank checking account, which is already part of M1. Credit cards and debit cards are methods for making payments, but they are not the money paid.
M1 money includes currency and traveler’s checks and personal checking accounts. In 2009 the total amount of M1 money in the US economy was about $1.7T.
A broader definition of money, M2, includes everything that’s in M1 plus saving accounts. Savings accounts are broadly defined as bank accounts on which you can’t write a check directly, but whose money you can easily access in other ways, as at an ATM or a bank. The point is you can withdraw and spend the money in M2, but it requires a greater effort and perhaps some penalty, whereas M1 can be spent very easily. In 2009, the total amount of M2 in the US economy was $8.5T.
Banks actually create money by the process of making loans. To understand how this happens, think about what happens to the money you get in the form of a bank loan, say for a car or a house. First, you pay the loaned money to someone else. They take the money and deposit it in their bank. The second bank takes it and makes a loan to someone else. Someone else takes that loan money and hands it over as part of another purchase, and the money is deposited in yet another bank. The banking system is a web of loans and deposits, in which loans are forming the basis for deposits, deposits are forming the basis for loans, and so on and so on. That process creates money because, as discussed earlier, money is what is in bank accounts. Thus, when money is loaned and reloaned, there’s actually more money in the economy.
Governors is designated by the US president and the board’s chairman. As a result, although members of the board are appointed by the president and confirmed by the Senate, after being appointed they are insulated from day-to-day politics.
The Fed buys and sells bonds with banks. When the Fed buys bonds from banks, the banks have more money to lend. Remember, bonds are not money. They’re not part of M1 or M2. A bank puts depositors’ money in bonds, but can’t lend out the bonds. When the Fed buys the bonds, the bank then holds cash instead of bonds, and can increase its lending.
The newest approach to monetary policy — known in theory but not used in the US until 2008 — is quantitive easing. It can work in two ways. One is that the Fed can lend money to participants in financial markets. These loans are typically short term, so during 2008 and early 2009 this approach was a way to ensure that big players in the financial markets had access to cash during a financial crisis, when usual sources of lending may have dried up. The other approach to quantitive easing is for the Feds to purchase longer-term financial securities. In 2009 and 2010 the Fed purchased US Treasury bonds and, in addition, more than $1T in financial securities backed by payments from home mortgages.
The Fed doesn’t have dictatorial powers to say, “We declare that interest rates must rise/fall.” Instead, the Fed uses its policy tools to affect the supply of funds that banks are willing and able to lend.
The Fed also acts as a bank for banks, so it plays a central role in clearing checks.
On that day, the Fed was out there effectively saying, “For anyone who needs money, we will loan it to you short term, at the discount rate, and in an almost unlimited amount.” It made this promise so that the financial system could keep working while the banks and institutions sorted everything out.
A central bank needs to be on guard against deflation. In fact, many central banks aim at an inflation rate of about 2 percent, rather than zero, because hey want a little wiggle room to avoid possible deflation.
The risk of overshooting means that monetary policy can create more economic fluctuations than it resolves. Say you go to a hotel room and the room feels very cold. You turn the thermostat up, but nothing seems to happen. It’s late, you’re tired, so you turn the thermostat way up and go to bed. Later that night, you wake up in a room that feels like a sauna. The lesson is that when reaction take some time to become evident, it’s easy to to too far.
No high-income nation conducts its monetary policy through the legislative or the executive branch of government. Instead, they all have set up their central banks as agencies that are somewhat independent of politics. Insulating the central bank from day-to-day politics gives its members the freedom to make tough decisions fairly quickly multiple times in a given year, which could be difficult if such decisions went through Congress. Further, there is concern that politicians would always be seeking more loans and lower interest rates; after all, politicians are unlikely to accept unpopular realities such as the natural unemployment rate, or the fact that monetary policy alone can’t quickly fix the aftermath of a housing bubble or a financial crisis. Political control over monetary policy could easily lead to an economy biased toward higher inflation.
A classic example arose in the 1970s, when Brazil decided to protect its own infant computer industry from import competition. By the later part of the 1980s, the Brazilian computer industry was about ten years behind the times, which in computer years is an eon. This wasn’t a problem only for the computer industry. Think of all the other Brazilian industries that use computers: finance, industry, communications — they were all trying to survive in the world economy with computers that were ten years out of date. An outdated and uncompetitive computer industry was bad enough, but in protecting that industry, Brazil hobbled its other industries as well.
In South Korea, the government subsidized certain industries such as heavy construction equipment manufacture, but if that industry didn’t reach a certain level of international sales within a preset time frame, all subsidies were cut off. Thus, short-term protectionism was accompanied by a predetermined deadline for competing in world markets. That said, for South Korea and other countries in East Asia, the fundamental reason for their economic growth is not infant industry policy, but high rates of investment in physical capital, education, and the adoption of new technology. While these countries protected a few infant industries, they gave even more help to old, aging industries such as agriculture.
If you asked a random sample of economists to name the three most difficult questions confronting mankind, the answers would probably be: 1) What is the meaning of life? 2) What is the relationship between quantum mechanics and general relativity? 3) What’s going on in the foreign exchange market?
Exchange rate fluctuation can bring on an even bigger problem. Say a bank borrows $1M, converts it at an exchange rate of 40 baht to the dollar, then lends it to a Thai firm. What happens if the baht loses half its value before the firm repays the bank? The bank won’t have enough money to repay its loan. It gets worse. Imagine Thailand’s government has deposit insurance, as most countries do. When the bank goes broke, the government is responsible for repaying bank deposits. So the government faces a massive budget deficit too.
Many low-income and middle-income countries do want a steady inflow of foreign financial investment, which not only brings in money for physical capital investment but often is accompanied by management expertise, international business contacts, sophisticated worker training, and improved technology. The trick for such nations is to make investment attractive to foreign investors but reduce the risk of a sudden U-turn in international financial flows, followed by economic collapse.
The IMF loans often come with conditions: for example, that a government must take steps to reduce certain kinds of subsidies, or reduce its budget deficits, or install more financial regulations. In some cases, the IMF has arguably gone too far, crossing the line from useful advice to dictating controversial details of economic policy. The difficulty is that the IMF is a little like the fire department: it’s useful, but it shows up only after the crisis has happened. It would be better to avoid starting the fire in the first place.
How vulnerable is the US to an international financial crash? The situation in the US is quite different from that in many small economies, in part because the US economy can borrow its own currency, so its banking system is less vulnerable to being whipsawed by fluctuating exchange rates. Indeed, if the exchange rate of the US dollar does fall, it reduces the cost of the debts that US companies owe to foreign investors. Much of the inflow of foreign financial capital to the US is in the form of assets with a variable return, such as stock and real estate, which in contrast to borrowed money are not forms of investment that require fixed payments, and so can lose value but not actually default.
World GDP was about $58T in 2009. World population was about 6.8B. Thus, per capita GDP for the world was approximately $8,500. The high-income countries combined produced 72 percent of world GDP with a per capita GDP of roughly $37,000. They have well-educated workforces and good human capital; they have strong rates of investment in physical capital; they are good at developing and using technology; and they have well-functioning market institutions.
The bulk of the long-term growth in this region can be attributed to good fundamentals: a very high savings rate, very high domestic investment rates, and a major effort to build human capital through expanding public education. These countries have had a great willingness to import technology and learn to use it well.
The Middle East has about 5 percent of world population and 2 percent of world GDP; per capita GDP is about $3,200. Given the geopolitical importance of this region — in a word, oil — it’s always a shock that in economic terms, the region isn’t very big.